Bailouts Force a Surge in Systemic Risk

Imagine you're a bank. What do you do at this juncture, wind down and go conservative or ramp up and take as much counterparty risk as you could get your hands on?

If you chose the former, you may be doing the responsible thing. But it would also be the stupid thing. Here are the smart things you can do to ensure your prosperity, or survival at the very worst, in this wonderfully morally hazardous world:

1. Stick your tentacles out as far as possible, and as deeply as possible, into other banks, preferably the biggest ones. Encourage your counterparties to do the same, but not directly. Rather, make long-winded chains so as to get around netting. Counterparty risk is your best insurance. The more counterparty risk others take on you, the safer you are.
2. With the counterparty web in place, take as big bets as you can get away with. If you win, you get rich, look smart, and get hailed as a hero. If you lose, no worries. The government will bail you out.

This is exactly what many banks have done since the first AIG bailout. The world before the Lehman bankruptcy may have been pretty screwed up in retrospect, but it was decidedly more sane than today in one aspect: risk carried at least theoretical downside. Back then, everybody would've stopped trading with AIG, C, and BAC if they had been in situations they're in today. Who in their right mind would trade with somebody who has a stock price of $0.35, with a market cap of less than $1B, and lost $60B in one quarter?

But that was stupid, of course; look what happened to Bear and Lehman. Now people have learned the lesson; let's continue trading. If you can't post collateral, no problem. Government will give you more cash or at least swap your ABCDO Squared Mezzanine into treasuries. Even if they don't, they'll give me more cash or at least swap my ABCDO Squared Equity into Fanny paper, which is about the same thing but worth a lot more.

Can you blame the banks?

Of course not. They're merely acting on their self-interest, which is exactly what they're supposed to do. It's the government's implicit guarantee of all companies that are mysteriously deemed too big to fail. All big banks have already been nationalized, except taxpayers pay all the price and get no control.

I know this question is in vain but still, I can't help asking: why is AIG still allowed to trade and be run by the same people as before? Just shut down everything except the insurance business, pay everyone $1M and ask them to please stay away from the office, go to Caribbean or go fishing, just go. Taxpayers would've saved a LOT of money. And it would've been much more fair and sensible, and with much less moral hazard than what the government has done.

Stock position: None.

Comments

[Leftfield:]

That's what I'm talking about.

Actually though, this article is based on common sense. Our leaders have told us that they know best even as they left the declining former middle class far behind in unprecedented wealth disparity. Along with common sense.

They are in their world of smoke and mirrors and have conned the voters nicely so far. More of the same is prescribed for all kinds of reasons, money does talk.

The perpetrators are in charge and voters are given every reason but common sense to rebuild this crazy ponzi economy. No guarantees, no accountability for the $trillions. Trust them.

We need only figure out how to live within our means finally. Not listen to banksters or DC saying, a few more trillions might give us the cure. Come on.

Obama says he'll cut the present deficit in half in a few years, AFTER we increase the deficit by a few more trillions.

The Alice in Wonderland schemes we're developing will lead to untold additional pain and allow ever more scamming then fall apart into some dead completely fascist state.

Jefferson said that if you pursue safety over liberty, you will have neither.

Mar 09 10:23 AM

[mr freddo:]

I am in agreement Bo. By propping up these organizations, we are feeding the crisis rather than resolving it. A forest fire used to be seen as a damaging event that must be stopped at all costs until we realized that it was all part of the ecosystem plan. By not allowing the fires, we inadvertently allow fuel buildup that sets the stage for a catastrophic event that takes out a few towns when it burns.

What about Merrill Lynch closing their last quarter with an unexpected trading loss of some 10 billion? I'll bet the traders were thinking as you suppose. Make the bet, you can't lose. The government will pick up the tab so you might as well bet big.

As we drag on into the third month of the year, it is apparent that nothing has been resolved. We haven't gotten much from Treasury. Why no suspension of mark to market? Why no resumption of the uptick rule and enforcement of naked short selling rules and penalties?

The Lehman bankruptcy scared everyone into believing that no institution can be allowed to fail due to counter party risk. The problem is that the problem is bigger than any government can tackle with its credit capability. How much can the USA credibly sign for?

This crisis is quickly passing the $10 trillion point and headed higher. Wouldn't it be better to stand aside, let the chips fall, and be ready with fresh capital to start new, clean banks in a brave, new world, with a CDS exchange, and capital controls in place to assure that people writing insurance policies actually have the cash to pay off on the policy?

This crisis is far from over. The story continues. Look for another spike in LIBOR, another freeze-up in the credit markets.

Mar 09 11:46 AM